Market jitters and Brexit uncertainty magnifies the chance of a flash crash

Dr Nafis Alam is Associate Professor of Finance and Director, Centre for Islamic Business and Finance Research, at The University of Nottingham. In this blog he reflects on the high level of volatility in the financial markets.

The British pound suffered a shuddering flash crash on October 7, plummeting more than 6% against the dollar to US$1.18, before recovering to US$1.24 in a matter of minutes. The precise cause of the crash remains unknown, but it reflects the high level of volatility in financial markets over Brexit.

Since Britain’s vote to leave the EU, the pound has been on a steady decline from the pre-referendum US$1.45 level. Increasingly tough talk about a “hard Brexit” by the UK’s prime minister, Theresa May, brought on a further slide and it was anticipated by financial analysts that the pound would go lower, but the crash was unexpected.

It was only temporary – a “flash crash” is the term given to a sudden large drop in the market, followed by a quick recovery. And the exact reason for the blip is unconfirmed, but there are a number of potential causes. It could have been caused by a “fat finger” trade, which is when a trade enters a wrong number – though this is unlikely, because when this happens it is usually wiped from the official record (and this has not happened).

Another possibility is that the crash was triggered by an errant algorithm. Although algorithmic trading is programmed to smooth out market volatility by increasing the volume of trades, sometimes its automated behaviour can lead to unexpected and significant transactions that cause big moves in the market. It has even been suggested that reports of tough talk by the French president, Francois Hollande, were picked up on by algorithms that scrape news websites and social media for breaking stories, causing a sharp, automatic sell-off.

Whatever the trigger, it shows how volatile trading is, due to the various political and economic factors surrounding Brexit. The uncertainty – in terms of its timeline, what it will look like and what effect this will have on the British economy – is extremely high at the moment. This means a jittery market prone to the kind of flash crash that took place on October 7.

Down she goes

But underpinning the crash is the downward movement of sterling, which has been steadily declining since the UK’s Brexit vote. This is a result of markets beginning to believe that Britain’s exit from the EU will be more chaotic and costlier for the UK economy than expected.

Clear indications that Britain is headed towards a hard Brexit would have monumental economic consequences for the national economy. In particular, the prioritisation of immigration controls over protecting trade and banking is expected to lead to economic losses, which is behind the decline in the value of sterling.

The million-dollar question is how low the pound could go. Opinion varies among analysts. The consensus is that the pound will hover around US$1.28 for the next six or nine months before edging back up to US$1.30 in the second half of 2017 and then tiptoeing up over the next few years, even ending up back at US$1.55 in 2020.

But what’s needed to ensure the bottom does not fall from underneath the pound is firm action from Britain’s prime minister so that markets know where they stand. Otherwise, the pound could be headed toward parity with the US dollar,as some have suggested.

Recent UK economic data has been promising such as consumer spending, manufacturing and construction (which has not slowed), but the pound has continued to fall against all major currencies – making it clear that the foreign exchange market is not driven by faith in this data. Traders and the market are likely more concerned about the impact of hard Brexit further down the line. Most of the recent data were published before the recent indications of a hard Brexit. Added to this have been strong statements by German chancellor, Angela Merkel, and French prime minster, Francois Hollande, calling on the EU to take a tough stance on the UK, if it insists on curbing immigration.

In the uncertain atmosphere of what Brexit actually means, the pound is therefore being driven downward by politics, as much as economics. How low it will drop is tricky to predict. The only thing that is certain is that its fate will remain extremely sensitive to the statements and emotions of both British and EU leaders on how the Brexit process unfolds.